Why do people give their money to Hedge Funds ?

I'm 19 years old, and started investing last year.

I bought Tesla stock from $672 on 7 May 2021, and then sold at $1017 on 16 October 2021. In 6 months, I made 51%+ without any knowledge, information, analysis or anything. If I bought stock of an another big company, like AAPL/MSFT I was going to make profit around 25%-40%.

I saw the returns of Hedge Funds this year, and it's pretty disappointing. The avarage return is around 15%-20%. Why do people give their money to Hedge Funds to invest ? I feel like if you invest into a company, and keep your money for the long-term, you would make a lot more profit.  What's the point ?

And, why hedge funds perform this bad ? Don't you guys have MBAs from M7, CFAs, BB IB experience, so many analysts and people. Am I missing something ?

Please, explain.

Comments (69)

Most Helpful
Jan 27, 2022 - 9:53pm
Pulisic69, what's your opinion? Comment below:

Btw you're gonna get a lot of hate comments on this post.

The main idea is that hedge funds will do all the deep digging and holding long-term for you.  Additionally, there's a certain risk agreed upon in the mandate which is why institutional investors will invest in hedge funds (there's a reason pension funds don't just dump everything into $SPY and let it sit, tho looking back it looks like a great investment now).  

Also, a lot of people think it's the same mechanical process from target high school -> H/S/W -> top IB group -> MF PE -> top HF.  However in HF, you don't necessarily need that type of background to make good returns and often times it's the creative thinkers who do well in the markets (also sprinkle in some luck). 

This point will be mentioned a lot but here's the deal:  2020-2021 was a great year for consumer and tech stocks no doubt.  I am NOT saying that ur just a dumbass who got lucky but yes you didn't need to do complex analysis to make money.  However, most of the time it's not easy to make money like that.  In fact look at the market right now, how are you doing as of now (unless you sold everything and parked into cash which is the smart thing for the time being). 

But what do I know I'm just a first year analyst lol. 

  • Investment Analyst in HF - Other
Jan 27, 2022 - 11:00pm

no. we're paid to manage and allocate risk where we see inefficiency. not to outperform a benchmark. if we beat mkt, that's a plus. in this business ur paid to capture and find spread, not growth. spread is everywhere.

  • Analyst 1 in IB - Cov
Jan 28, 2022 - 10:34am

Okay, maybe the goal isn't to beat the s&p, but what is provided in the above comment that a financial advisor doesn't give you along with lower fees? Hedge funds don't outperform compared to any other method of investment because it's been proven time and time again that any risk-adjusted alpha is all luck. Unless you're throwing money to Ren Tech or some fund that trades insider info, you're just paying 2/20 to glorified CutCo salesman.

Jan 28, 2022 - 9:34am
Legion42, what's your opinion? Comment below:

The real reason is that they are supposed to be uncorrelated from market downturns. Its seen as a "hedge" hence the name. While many question the practicality of investing in HFs, I believe it makes sense to invest in the top HFs as on a risk adjusted basis the returns will normally beat the markets.  

Jan 28, 2022 - 10:56am
networking_capital, what's your opinion? Comment below:

The idea is that hedge funds generally should provide absolute returns, which means that no matter the market conditions they should generate positive return. It's different compared to your typical mutual fund which usually has some sort of a benchmark like S&P500 and generates relative returns i.e. relative to a benchmark. This means that the returns from a hedge fund should be uncorrelated with the market, which is very important for institutional investors.

Think of a large pension fund like Calpers that has to manage their liabilities in time. It needs to have enough money to cover pension payments regardless of market conditions. What if the market crashed and their public stock portfolio took a beating? They still need to pay out pensions. That's why they look to the alternative investments space like hedge funds, private equity, real estate, infra etc., because they offer returns that are in large part not correlated with the public markets. So a stream of consistent, positive returns even during downturns is very valuable to these investors.

Retail investors generally don't invest in hedge funds, you need to be a certified investor and pass some requirements regarding net worth and yearly income. And besides, such investment strategies are more useful for institutions than for retail.

Truth be told there is something like 10,000 hedge funds out there and not all of them focus on equities. You have macro, credit, distressed, quant, commodities and even within equities you have many different strategies like L/S, activist, merger arb. They all have different risk/return profile. This is also why comparing generic HF returns to S&P500 makes no sense. But of course everyone is a stock genius during the longest bull market in history.

Jan 28, 2022 - 1:08pm
Ferris Bueller, what's your opinion? Comment below:

Second paragraph nails it as to why the broad diversification is necessary and not to park all assets that have similar beta or no hedging mechanisms. Outflows of liabilities are getting to be much larger than inflows these days. Even real estate investments generally is going to be decently illiquid outside of dividend payments.

  • Analyst 1 in IB - Gen
Jan 28, 2022 - 10:56am

Risk-adjusted return on capital from professional teams spending 100% of their time trying to get those returns. 

The average joe probably doesn't care about risk-adjusted returns so a cheaper mutual fund or index fund makes more sense to them. Wealthy individuals and institutional asset owners do care about risk-adjusted returns. 

In terms of allocation, HFs tend to be a relatively small portion of asset allocation vs broad equities, broad FI or private capital for those types of investors anyway. 
 

Jan 28, 2022 - 11:40am
Smoke Frog, what's your opinion? Comment below:

If your family already has money or you have a high earning job that you believe you can reasonable hold for twenty years with ease, like a doctor for example, then you can invest your money vanguard total market for twenty years and retire.

The main issue with passively investing in the market over 20 or 30 years is that you won't get rich fast. It takes time for your principal to grow and let the power of compounding interest work. It's boring and not sexy. And takes time.

People on the board will mention that hedge funds manage risk, should not be benchmarked against the broader market and are used to balance our risk for a wider financial portfolio. It's all trade speak. People invest in hedge funds to make outsized returns. They want that fast buck, they want that unicorn investment, they want to hit that home-run.

So the main reason people run hedge funds is that the comp is really sweet if you run your fund and have a few successful years. Money will flow to you as investors chase returns. And if your fund blows up, well it's not all your money so who cares.

And the main reason rich people and pensions tap hedge funds is to earn that outsized return. Sometimes they don't have the patience to wait 30 years, they need a return now.

I also have a theory that rich and successful people just can't accept that passive investing is the best way. They are used to fast success. They believe an advisor or a hedge fund can get them that inside info or that edge to that hot new fund. So many of my dads friends pay advisors for mediocre returns, but they all remember that one home run investment and talk about it constantly while ignoring all the sub par investments that drag down returns. My father in law used an advisor for years until I showed him how much he would have had if he had just taken his money and dollar cost averaged into the market over his career.

  • Investment Manager in HF - Other
Jan 28, 2022 - 1:20pm

This is wrong. 

Pensions, etc don't invest in HFs for outsized returns. This was hit on by a previous poster (and very clearly put so I won't spend much time on this, just read the post), they do it for consistent returns due to their liabilities. Please just do some basic research before throwing out misinformation. 

Jan 28, 2022 - 1:39pm
Smoke Frog, what's your opinion? Comment below:

If a pension wanted to match its liabilities it would simply allocate towards highly rated bonds.

The vast majority do not invest in hedge funds to manage future liabilities. They tap hedge funds to grab that alpha c'mon now man.

Why use a hedge fund when you can use IG or hy or tips or treasuries or any other vanilla product to hedge? 

Jan 28, 2022 - 1:37pm
AnalyzeANDchill, what's your opinion? Comment below:

did you ever show him buffet or other fund managers who have outperformed the market? I agree for many indexing is good but people act as if its impossible to do better than indexing and its not its tuff but if you want to know why fund managers exist thats why.

Oh and before you say it, many funds are about consistent returns or downside risk (hence the hedge part in hedge funds) its not always just how much money can we generate in a year taking these insane risk and throwing everything into one stock. 

Jan 28, 2022 - 1:50pm
Smoke Frog, what's your opinion? Comment below:

No doubt there are buffets of the world that can generate alpha over the long term, but the passives argument is that we don't know who these future stars are and we also cannot separate the lucky managers from the true star managers.

So it's a gamble finding these future stars.

If you have hundreds of millions of dollars, then I am sure a hedge fund is needed for those family offices. Or if you're some huge pension of swf and need some esoteric investment strategy, then hedge funds can help.

But for people worth $50mm and below, you don't need a hedge fund and the main reason these high net worth people jump to hedge funds is that they just want to take an active hand in their investments and want the home run. My father in law still leaves some money with advisors and hedge funds and he tells me the same thing other rich people have told me. Indexing is boring / he believes the advisor has inside knowledge and gets him access to early stage investments / he wants a more active hand in his investments.

I really think it comes down to some people always wanting to beat the average. They have superstar mindsets, it's what made them successful in their careers, and the simply believe the same thing can be applied to investing, even though numerous evidence has shown it's rare to beat the market.

Jan 28, 2022 - 1:55pm
Smoke Frog, what's your opinion? Comment below:

Yes they do. They all allocate a small percentage to nonsense like PE, alternatives, real estate, infrastructure, commodities and precious metals.

If they would just stay the course with passive indexing with some low yield bonds they would be fine.

But the pension directors need to justify their paychecks. What pension board would be ok paying people to simply index lol.

Just go on Bloomberg and compare the s&p 500 to a hedge fund index or pe index or whatever you want. Very few beat the market, and you have to be able to time correctly getting in and out of positions. It's simply too hard to do consistently.

But like I said, if you get hot for a few years, think of someone like David Einhorn, you're set for life.

Jan 28, 2022 - 1:33pm
AnalyzeANDchill, what's your opinion? Comment below:

well first off because hedge funds hedge. People always just compare absolute returns when the market last 10 or so years has been going straight up . The hedge funds will protect downside risk, maybe give you a specific technology or sector or a number of other things. For instance there are tail risk funds that generally do horrible and then when 2020 came around during the sell off they made 2-3 thousand percent. So its not always as simple as comparing absolute returns when the market is going straight up . 

Jan 28, 2022 - 1:48pm
wallace18, what's your opinion? Comment below:

Why did you sell? This post is trolling and should have been removed  

Jan 28, 2022 - 1:55pm
IncomingIBDreject, what's your opinion? Comment below:

As others have mentioned the point is to hedge your money and have returns that aren't dependent on the markets. Hedge Funds can invest in exotic derivatives as well as startup companies, among many other esoteric spaces that your traditional retail investor can't due to regulation. 

I know academics and others alike will push the idea of EMH and SPY is the way to go, but even though SPY on an annualized basis does fairly well, it was down 40% in 2008 and down 10-20% every year the tech bubble burst ('00-'02). Say you had $50M in SPY in '07. By the end of '08 you had roughly $30M. That's 20M gone, and it's not easy for people to sleep thinking that much money is gone. The concept of "oh it will come back later" isn't a guarantee because recessions can hold out like the great depression. 

All of this is to say index funds do poorly during economic downturns, so the purpose of investing in actively managed funds is to mitigate losses during a downturn. 

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Jan 28, 2022 - 4:20pm
A jar, what's your opinion? Comment below:

also dont forget there is a real chance that the s&p could theoretically not return to its nominal high

Jan 28, 2022 - 4:55pm
NoEquityResearch, what's your opinion? Comment below:

If I don't want to beat the market but want something less risky, I can do that without a hedge fund also....

Plenty of lower Beta index portfolios out there. Plenty of assets mixes where I can allocate my portfolio to less risk exposure.  So the argument that the point of hedge funds is to not beat the market but reduce risk instead doesn't hold either. I can also reduce risk myself with plenty of assets that don't beat the market.

So, the only point of investing in a hedge fund is if you believe that a hedge fund can beat that same lower Beta index fund or portfolio with less risk, post-fees. It again goes back to, can you beat an index or not....we're just talking about a less risky index than the S&P.

Jan 28, 2022 - 6:40pm
Shadows, what's your opinion? Comment below:

Well HFs are part of an asset mix. It is very rare to see an investor putting all his money on a single HF.

Pension funds, the main HFs clients, allocate between traditional asset classes and a mix of HFs. The goal of adding HFs in the allocation is the same as adding bonds or real estate (2 asset classes that have also underperformed the S&P): it is to add diversification and generate returns that are not too much correlated to the other components of the allocation.

Pension funds have important risk limits to respect. So their goal is to maximise returns while respecting these risk limits. And they cannot do this by going 100% long S&P.

Jan 28, 2022 - 8:36pm
NoEquityResearch, what's your opinion? Comment below:

Yes, it's an asset class that invests in other asset classes....so why not just invest in those other asset classes.  It sort of becomes circular.

Also, I agree that their returns may not be correlated but this is a bit of an illusion.  It is important to know why they are not correlated.  Take this example. Suppose my hedge fund is long the S&P 500 and nothing else. The market starts crashing this month and is down 15%. My hedge fund liquidates all of its holding.  Over the next year the market, drops a total of 25%.  If I look at the returns for that year, they will not look very correlated but what value is really happening that I couldn't do myself? Am I really buying risk diversification?

Furthermore, here is the next big mistake. Suppose next year I'm building my portfolio. I look at the hedge fund that was lowly correlated and wow I want to add more to my portfolio right? Sure, great, but I have no clue how that correlation will stack up next time....because hedge funds are not truly a different asset classes i.e. they only invest in other assets and those investment decisions are discretionary and can change.  Suppose the same fund manager sellers down 24% next time, bottom ticks the market, and the marekt shoots up this time. Given the active nature of the investment, the correlation, betas, etc will not be nearly repeatable or predictable as an index fund with the same holdings.

EDIT: To give a real example, suppose I'm choosing between investing in Greenlight Capital or US Treasury to diversify my portfolio and protect myself in a crash. If the market crashes next month, there is a very high chance that whatever the reason US Treasuries will go up. However, what is the chance that David Einhorn nails it during this crash, exactly like the last crash....probably not as predictable.

Jan 28, 2022 - 10:59pm
IncomingIBDreject, what's your opinion? Comment below:

I'm not too sure what you're argument is because hedge funds are essentially portfolio strategies across different asset classes (depending on strategy) that can depending on strategy seek lower variance returns. Theoretically you could do it yourself and if you have enough capital you could invest in derivatives and startups and the other esoteric avenues. But the point is most wealthy people either don't have the time or the financial acumen or both to actively build and maintain their own portfolios in the fashion you're describing. Do you think the IB MD has time to do this? Do you think the actor has the financial acumen to do it? That's the whole point of hedge funds. Financially and mathematically talented individuals who have been studying the markets for years invest on behalf of those who don't have the time or really don't know how to do it.

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Jan 28, 2022 - 8:23pm
Fillycheesesteaks, what's your opinion? Comment below:

This is a very good question and shouldn't be shut down especially from a 19 year old. I didn't really have a good answer until reading a few of the good comments here. 

  • Analyst 1 in AM - Other
Jan 29, 2022 - 12:23am

OP sounds like the type of person who would diamond hand GME or AMC

  • PM in HF - Other
Jan 29, 2022 - 1:16am

Let's get something clear kid, you did not start an investing account you started a trading account and made some nice trades. Well done. Now if after 1 week your APPL trade went bad how would you react, can you get in touch with Tim Cook to see what dealio is, if you could would you be more relaxed?

Next, person A has 100mm, he returned 7% last year, you have lets say 5k, you made X%. Whos net worth went higher? What if that dudes return was 35%, thats a lot offff APPL trades for you.

Will let others argue the academics, passive investing etc…World aint fair, as the numbers get larger the risks get larger…but dudes with bigger #s still winning.

So understand what you did and take that money and do it right next time. But the casino will always welcome you back, even add margin.

Jan 29, 2022 - 8:29pm
BlahBlahBlah1234567890, what's your opinion? Comment below:

The ticker is AAPL and it's also the top constituent in the S&P lmao

Jan 29, 2022 - 9:34am
TheBuellerBanker, what's your opinion? Comment below:

Separate asset class. They aren't there to beat the market but rather provide a vehicle for risk-adj. returns for investors. Given they focus on public markets, it's easy to make the claim that investing in the market or single security as a whole could outperform HFs as a whole but that isn't the point. 

  • 1
Jan 30, 2022 - 6:36am
bigdaddybongdong, what's your opinion? Comment below:

I don't know why people threw monkey shit on you, but as a high-schooler who wants to work at a hedge fund, I didn't know either lol

Helpful post, thanks.

  • Associate 1 in HF - Other
Jan 30, 2022 - 10:57am

Hmmmm, first off, the more capital you have, the harder it is to achieve return. Very hard to scale up.

If you dump a large order into market, price could surge and you wont be filled at desired price. If you're a retail trader, you dont need to care.

Feb 2, 2022 - 10:06pm
hard.work.no.sleep, what's your opinion? Comment below:

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Feb 19, 2022 - 3:36pm
guy_incognito, what's your opinion? Comment below:

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